The Audit

Process
Principles, Practice and Cases
Seventh Edition

By Iain Gray, Stuart Manson, Louise Crawford

For use with The Audit Process. Principles, Practice and Cases, seventh edition by Gray, Manson, Crawford
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Chapter 2:
An overview of the
postulates
and concepts of auditing

For use with The Audit Process. Principles, Practice and Cases, seventh edition by Gray, Manson, Crawford
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Learning objectives
• To explain how auditing theory, concepts and principles underpin
auditing practice.
• To identify the basic postulates of auditing and explain why they are
important.
• To define auditing concepts under the general headings of credibility
of the auditor, process of audit, communication by the auditor and
performance of the auditor’s work.
• Explain the implications of truth and fairness, or ‘presents fairly in all
material respects’, in relation to financial statements and the work of
the auditor.
• Define the audit expectations gap and identify its components.
• Understand that the regulatory framework of auditing provides the
criteria by which audits are conducted and encompasses the concepts
of auditing.
• Recognize how organizations attempt to control their internal
environment in the context of external influences.
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The importance of theory and concepts in
underpinning auditing practice
• Mautz and Sharaf (1961):
One reason… for a serious and substantial investigation into
the philosophy and nature of auditing theory is the hope that it
will provide us with solutions, or at least clues to solutions, to
problems that we now find difficult.
• A philosophy (or set of unifying theories) has three
aspects of value to us:
1. Gets back to first principles, to the rationale behind the
actions and thought which tend to be taken for granted.
2. Concerned with the systematic organization of
knowledge in such a way that it becomes at once more
useful and less likely to be self-contradictory.
3. Provides a basis whereby social relationships may be
moulded and understood.

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The postulates of auditing 1–4

1. The primary condition for an audit is that there is a

relationship of accountability or a situation of public
accountability.
2. The subject matter of accountability is too remote, too
complex and/or of too great a significance for the discharge
of the duty to be demonstrated without the process of audit.
3. Essential distinguishing characteristics of audit are the
independence of its status and its freedom from investigatory
and reporting constraints.
4. The subject matter of audit, for example, conduct,
performance or achievement or record of events or state of
affairs or a statement of fact relating to any of these, is
susceptible to verification by evidence.

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The postulates of auditing 5–7

5. Standards of accountability, for example, conduct,

performance, achievement and quality of information, can
be set for those who are accountable: actual conduct, etc.
can be measured and compared with these standards by
reference to known criteria, and the process of
measurement and comparison requires special skill and
judgement.
6. The meaning, significance and intention of financial and
other statements and data, which are audited, are
sufficiently clear that the credibility given thereto as a
result of audit can be clearly expressed and communicated.
7. An audit produces an economic or social benefit.
For use with The Audit Process. Principles, Practice and Cases, seventh edition by Gray,6Manson, Crawford
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The concepts of auditing: credibility,
process, communication, performance

• CREDIBILITY: competence, independence and ethics,

due care

• PROCESS: risk, evidence, professional judgement and

professional scepticism, materiality

• COMMUNICATION: reporting, truth and

fairness/presented fairly, association

• PERFORMANCE: standards, quality control

For use with The Audit Process. Principles, Practice and Cases, seventh edition by Gray,7Manson, Crawford
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Figure 2.1

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Components of the audit expectations
gap
1. Reasonableness gap: arises because people expect more of an
audit than it can give in practical terms.
2. Performance gap: between what can reasonably be expected of
auditors and what they are perceived to do. This gap is split into
two:
– Deficient standards gap: gap between what auditors can be
reasonably expected to do and what the profession and the
law asks them to do.
– Deficient performance gap: arising because auditors have not
behaved in a manner consistent with professional auditing
standards.
3. See structure of audit expectations gap on slide 10.
4. Gap discussed further in Chapter 20.

For use with The Audit Process. Principles, Practice and Cases, seventh edition by Gray,9Manson, Crawford
978-1-4737-6018-9 © 2019 Cengage Learning EMEA
 Figure
2.2

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Audit quality (1)

• Frameworks for audit quality published by FRC and IAASB:

– focus on identifying elements that contribute to an effective
audit and financial reporting environment
– aim to raise awareness of the indicators of audit quality and of
ways to improve quality.
• European Audit Directive and Regulation (2014) – objective of
improving audit quality across the EU and to ensure auditors are
key contributors to economic and financial stability.
• Understanding the elements of the audit expectations gap gives
insight into how different stakeholders might view audit quality.
• European Internal Market and Services Commissioner, Michel
Barnier, links audit quality to fundamental auditor attributes of
independence and competence, and also to the meaningfulness of
audit reporting.
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Audit quality (2)
• Neither FRS, the IAASB framework nor EU define audit quality.
• But DeAngelo (1981) defines it as: ‘the market assessed joint
probability that a given auditor will both discover a breach in a
client’s accounting system, and report the breach’.
• FRC (2006) acknowledges no single agreed definition of audit
quality as a standard against which actual performance can be
assessed.
• Key elements contributing to audit quality change over time, but
general acceptance that auditor competence & independence are
key attributes of audit quality.
• FRC (2006) – limited transparency about the audit process and
what audit firms actually do – stakeholders cannot reliably assess
audit quality – contributes to audit expectations gap.
• Further discussion of audit quality in Chapter 20.
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Manson, Crawford
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Corporate Governance (1)
Definition
• Corporate governance is the system by which companies are
directed and controlled. Boards of directors are responsible
for the governance of their companies. The shareholders’
role in governance is to appoint the directors and the
auditors, and to satisfy themselves that an appropriate
governance structure is in place. The responsibilities of the
board include setting the company’s strategic aims,
providing the leadership to put them into effect, supervising
the management of the business and reporting to
shareholders on their stewardship. The board’s actions are
subject to laws, regulations and the shareholders in general
meeting (UK Corporate Governance Code, 2016, p. 1).

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Corporate Governance (2)

• Corporate governance (CG), in addition to

corporate audit, is a mechanism for monitoring
corporate behaviour on behalf of shareholders and
other stakeholders.
• Part of Layers of Regulation and Control (slide 16)
• CG and corporate audit failures in recent years have
led to disquiet.
• See rounded discussion of CG in Part 1 of
Chapter 5.
• See Models of CG and the UK CG Code in Part 2 of
Chapter 5 and Reporting on CG – Chapter 18.
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Public interest
• Difficult to define but in context of corporate audit, public interest
would seem to be served if the public are protected from corporate
collapse scandals, and capital markets are perceived as credible,
reliable and trustworthy.
• This is an arguably narrow and capitalistic view of ‘public interest’
and there are many stakeholders other than shareholders, e.g.
employees, creditors, depositors, who may be affected by corporate
behaviour.
• The idea of ‘public interest entities’ extends the notion of public
interest to capture other stakeholders.
• Public interest entities defined by EU are entities ‘whose
transferrable securities are admitted to trading on … regulated
markets … credit institutions … & insurance undertakings. Other
entities may be defined as public-interest entities of significant
public relevance because of the nature of business, size or number
of employees. See margin note on page 759.

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6

Layers of regulation and control

Figure 2.3

For use with The Audit Process. Principles, Practice and Cases, seventh edition by Gray, Manson, Crawford 16
978-1-4737-6018-9 © 2019 Cengage Learning EMEA